In 2013, investors were going crazy for Chipotle Mexican Grill's (CMG 2.41%) stock. Share prices jumped 79% over the year as the market cheered the company's record-high revenue and profits. This fueled a ravenous appetite for new investment opportunities in the restaurant space, motivating Noodles & Company and Potbelly to both have initial public offerings (IPO) that year.
Shares of both Noodles & Company and Potbelly more than doubled in their first days of trading and were compared to red-hot Chipotle by Wall Street. But those investments haven't panned out. Both stocks are down significantly from their 2013 highs.
Meanwhile, Chipotle stock is once again hitting all-time highs thanks to record financial results. That outsized performance has brought another restaurant stock to market that's drawing Chipotle comparisons: Cava Group (CAVA 10.50%).
It's very valid to compare Cava to Chipotle. But while Cava's business measures up in important operating metrics, there's one thing that Wall Street is still getting wrong with this story.
Why Cava's comparison to Chipotle is valid
As a starting point to understanding its success, investors should know that Chipotle has some of the highest average unit volumes (or AUV, meaning the amount of sales each of its 3,200 locations generates in one year on average) in the restaurant business. In the first quarter of 2023, it was nearly $2.9 million.
Having high AUV allows Chipotle to leverage restaurant-level operating expenses and turn a high profit. As of Q1, the company's restaurant-level operating margin was a very high 25.6%. This figure excludes expenses at the corporate level. For this reason, Chipotle doesn't franchise. Instead, all locations are company-owned. This keeps all of those juicy profits in-house.
For its part, Cava operates a Mediterranean-inspired restaurant chain with 263 locations as of the first quarter of 2023. And these also have high AUV. As of April 1, Cava's AUV was hitting an all-time high of over $2.5 million -- that's close enough to Chipotle's to be a valid comparison. As you'd expect with high AUV, Cava also has strong restaurant-level profitability just like Chipotle. Its restaurant-level profit margin is 25.4%. No wonder Wall Street is upbeat.
For this reason, Cava made the same decision as Chipotle: It doesn't offer franchise opportunities. The unit economics are simply too good to let someone else rake in the profits. It should go without saying, but few restaurants can go toe-to-toe with Chipotle's unit economics. But Cava is a rare case where the comparison indeed holds water.
Here's what Wall Street is missing
Readers might think I'm about to criticize Cava's profitability. After all, in 2005, leading up to Chipotle's January 2006 IPO, it had net income of $37.7 million, for a profit margin of 6%. By contrast, Cava is unprofitable, with a net loss of nearly $60 million in 2022.
However, Chipotle was a bigger company (489 locations) than Cava at the time of its IPO, and that makes all the difference. As mentioned, restaurant-level profitability excludes corporate expenses. And corporate expenses are a bigger deal for smaller chains. As they grow, these expenses become a smaller percentage of revenue if management is disciplined.
For perspective, Chipotle was also unprofitable in 2003 when it had fewer than 300 locations. That year, general and administrative expenses came in at 10.9% of revenue. As of Q1, it's just 6.3% of revenue. Therefore, it's reasonable to assume Cava can become profitable with growth just like Chipotle did.
Here's what Wall Street is truly missing: Cava's valuation at IPO compared to Chipotle Mexican Grill. With a market capitalization of $5.4 billion and trailing-12-month revenue of $608 million, Cava stock trades at a price-to-sales (P/S) ratio of almost 9.
For comparison, Chipotle trades at a P/S of 6.4 right now. But when it went public in 2005, it traded at a P/S below 2.5.
If you'd invested $1,000 in Chipotle stock in early 2006, you'd have over $46,000 now. Business growth has led to these sensational returns. But investors can't deny the power of its valuation going up as well.
Let's assume that Chipotle traded at a P/S valuation of 6.4 at its IPO (like it does now) instead of 2.5. In that scenario, total investment returns would have been about 60% lower because its valuation didn't go up.
With Cava stock already trading at a higher valuation than Chipotle ever traded at any point in its illustrious history, I believe it's reasonable to expect its valuation to drop over time, not go up like Chipotle's. And that could put a damper on investors' returns, even if the business lives up to its Chipotle comparisons.
In investing, the business and the stock are different things. With Cava, it's clearly one of the best restaurant businesses to go public in a long time. But with Cava stock, I don't believe it will be the strong investment opportunity that Chipotle was until its valuation becomes far more reasonable.
